The Secret Life of Bitcoin: From Seedy Past to Cloudy Future?

May 3, 2014

During the past several years, the world of virtual currencies has exploded, of which bitcoin has been the most popular. The growth in virtual currencies has been driven by a desire to avoid banks and regulators. The fist thing to know about bitcoin (and all virtual currencies) is that this is unregulated territory. There is no Central Bank oversight, no FDIC, and no proof of ownership other than what the owner retains on a computer or in a “key” identifier. There is no one standing by to help when a trading firm goes bust. When it comes to virtual currency, users want it virtual, not lost.

The value of a bitcoin was $1 for the first time on February 9, 2011. During 2013, the value of a bitcoin was $13 at the beginning of the year and peaked at $1,147.25 on December 4th. The run up in pricing attracted more “investors”, who used trading firms to buy and sell the virtual currency. One of them was Mt. Gox, a Tokyo-based firm that at one time handled 80% of the bitcoin trading volume. On February 28, 2014, Mark Karpeles, the CEO of Mt. Gox, admitted that the firm had lost almost $500 million and up to $750 million of its customers’ bitcoins before filing for bankruptcy. The failure of Mt. Gox had the value of bitcoin plummeting to under $500. Mt. Gox later announced that it had found $116 million (20,000 “coins”) in “old-format wallets” which are basically locations on a hard drive or server. For countless owners, the virtual currency had disappeared, and their chances for recovery are not promising.

The evolution of bitcoin
The bitcoin was developed in 2009, by an individual or group who has to date remained anonymous, going by the name of “Satoshi Nakamoto”. A fixed number of approximately 21 million bitcoins has been created, but they must be “mined” or discovered to be used; this process requires very powerful computers capable of solving complex math. Bitcoin can also be earned as a transaction fee when processing payments. Bitcoin was initially used by those wanting to conceal their identity for illegal activities, including drugs, weapons, fake documents, child pornography and to obtain services like hit men and computer hackers. It can be used to side-step anti-money laundering laws, banking regulators and fees paid to banks for credit card transactions. During 2013, the FBI completed its investigation of Silk Road, which their New York cyber-crime unit called “the most sophisticated and extensive criminal marketplace on the Internet today.”

In October 2013, the FBI shut down the Silk Road site, seized all its property (which included 26,000 bitcoins worth approximately $4 million), and arrested its founder, Ross Ulbricht. In January 2014, the Manhattan U.S. Attorney’s Office announced the arrests of Charlie Shrem, who operated bitcoin exchange firm BitInstant and was vice-chairman of the Bitcoin Foundation, and Robert Faiella; both were accused of a money-laundering conspiracy using Silk Road. In early December 2013, Sheep Marketplace (a black market drug exchange that re-placed Silk Road) announced that it had been “robbed” of 5,400 bitcoins, worth about $5.6 million. Trading in bitcoin has a series of risks, not the least of which is that you do not know if the person on the other side of the trade is trustworthy. Hacking has been claimed as one of the loss hazards; there have been several reports of stolen bitcoin that we would expect to continue. Also, a bitcoin owner may die with their secret key identifier or digital wallet unavailable to heirs. How do you prove your rights to a virtual currency in a virtual wallet if you lose your key or your hard drive crashes?

Is there a future for bitcoin?
The fact that there are thousands (maybe a million) of users of bitcoin and a growing number of vendors accepting it seems strange to us, but there are some smart minds behind it. Among the believers in bitcoin are the Winklevoss twins (who fought Mark Zuckerberg over the founding of Facebook); their firm, Winklevoss Capital, provided financing of $1.5 million to BitInstant. The arrest of Shrem caused them some angst, however, they have created the Winkelvoss Bitcoin Trust ETF (waiting for regulatory approval) and the Winkdex (index for bitcoin). Other bitcoin ETFs have already launched, trying to capture the enthusiasm for its potential; it is critical to remember that they are not regulated investments.

Supporters view the bitcoin as the most viable crypto-currency. In November 2013, former Fed Chair Bernanke told Congress that virtual currencies “may hold long term promise.” With each click online, we move closer to a cashless system of electronic payments. However, electronic toll payment systems E-ZPass and SunPass, credit cards and debit cards still rely on the faith and confi dence in a traditional currency that is under the watch of a central bank. We may gradually eliminate the need to print dollars or euros for circulation, but we believe that we will still need them as core currencies for the majority of secure global transactions.

Two of the largest emerging economies have taken action against bitcoin. In February, Russia warned its citizens against using bitcoin and that the use of any currency other than the ruble is illegal. In December 2013, China declared that bitcoin is not a currency and on April 1st the government ordered all commercial banks and payment firms to close bitcoin accounts by April 15th. Central Banks in the developed markets have been silent but may need to revisit their position following the failure of Mt. Gox. In the U.S., the IRS announced on March 25th that bitcoin does not qualify as currency and classifi ed it as property for tax purposes (requiring owners to track cost basis).

While there are a growing number of small businesses that are accepting bitcoin as payment, it is too early to give up other payment methods. You cannot seamlessly travel or conduct everyday life using bitcoin. We advise against seeing it or any other crypto-currency as an investment. Consider it as an experiment in a lab in which periodic explosions are likely. The element of secrecy that made bitcoin appealing may prove to be its fatal flaw.

Bitcoin was initially used by those wanting to conceal their identity for illegal activities, including drugs, weapons, fake documents, child pornography and to obtain services like hit men and computer hackers. It can be used to side-step anti-money laundering laws, banking regulators and fees paid to banks for credit card transactions. During 2013, the FBI completed its investigation of Silk Road, which their New York cyber-crime unit called “the most sophisticated and extensive criminal marketplace on the Internet today.”

In October 2013, the FBI shut down the Silk Road site, seized all its property (which included 26,000 bitcoins worth approximately $4 million), and arrested its founder, Ross Ulbricht. In January 2014, the Manhattan U.S. Attorney’s Office announced the arrests of Charlie Shrem, who operated bitcoin exchange firm BitInstant and was vice-chairman of the Bitcoin Foundation, and Robert Faiella; both were accused of a money-laundering conspiracy using Silk Road. In early December 2013, Sheep Marketplace (a black market drug exchange that re-placed Silk Road) announced that it had been “robbed” of 5,400 bitcoins, worth about $5.6 million. Trading in bitcoin has a series of risks, not the least of which is that you do not know if the person on the other side of the trade is trustworthy. Hacking has been claimed as one of the loss hazards; there have been several reports of stolen bitcoin that we would expect to continue. Also, a bitcoin owner may die with their secret key identifier or digital wallet unavailable to heirs. How do you prove your rights to a virtual currency in a virtual wallet if you lose your key or your hard drive crashes?

Is there a future for bitcoin?
The fact that there are thousands (maybe a million) of users of bitcoin and a growing number of vendors accepting it seems strange to us, but there are some smart minds behind it. Among the believers in bitcoin are the Winklevoss twins (who fought Mark Zuckerberg over the founding of Facebook); their firm, Winklevoss Capital, provided financing of $1.5 million to BitInstant. The arrest of Shrem caused them some angst, however, they have created the Winkelvoss Bitcoin Trust ETF (waiting for regulatory approval) and the Winkdex (index for bitcoin). Other bitcoin ETFs have already launched, trying to capture the enthusiasm for its potential; it is critical to remember that they are not regulated investments.

Supporters view the bitcoin as the most viable crypto-currency. In November 2013, former Fed Chair Bernanke told Congress that virtual currencies “may hold long term promise.” With each click online, we move closer to a cashless system of electronic payments. However, electronic toll payment systems E-ZPass and SunPass, credit cards and debit cards still rely on the faith and confi dence in a traditional currency that is under the watch of a central bank. We may gradually eliminate the need to print dollars or euros for circulation, but we believe that we will still need them as core currencies for the majority of secure global transactions.

Two of the largest emerging economies have taken action against bitcoin. In February, Russia warned its citizens against using bitcoin and that the use of any currency other than the ruble is illegal. In December 2013, China declared that bitcoin is not a currency and on April 1st the government ordered all commercial banks and payment fi rms to close bitcoin accounts by April 15th. Central Banks in the developed markets have been silent but may need to revisit their position following the failure of Mt. Gox. In the U.S., the IRS announced.

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